Flat Fees vs. AUM Recap: The Good, the Bad and the Really?

While it's certainly true that "markets produce performance," this observation completely ignores the fact that clients only benefit from market performance if they are 1) in the market; 2) not reducing their performance through excessive fees and loads; and 3) not devastating their investment portfolios through poor life decisions. Advisors add value by helping their clients avoid these mistakes. The result is larger client portfolios — why shouldn't advisors get paid on this success?

Advisors who are compensated by AUM fees take a hit to revenues every time the markets go down. Many flat fee advocates point out the dilemma that when markets — and revenues — go down, advisors' workloads (in terms of client handholding and communications) go up. This is a problem for advisors, yet it's not unique to the independent advisory industry: Financial services companies and financial publishing firms have been dealing with this challenge for well over 100 years. While some have been more successful meeting it than others, very few have successfully become "market neutral."

To many observers of today's advisory world, replacing AUM fees with flat retainer fees doesn't seem to be a promising solution to that issue. The biggest problem appears to be the reverse effect that flat fees have on the amount that clients pay for advice. Consider a client with $1 million in AUM paying his advisor 1%, or $10,000, a year. If the advisor converts to flat advisory fees, the annual fee will more than likely work out to be around $10,000 a year, so the client doesn't see any real difference.

That is, until the markets suffer a major correction. If it's as bad as the one in 2008-2009, the client's portfolio is now worth $500,000, which, as we know, isn't a disaster as long as the advisor does his or her job and keeps the client from panicking and selling out before the market recovers.

Under the new flat-fee arrangement, the client is still paying an annual fee of $10,000, which keeps the advisor's revenues nicely flat. However, from the client's perspective, that $10,000 annual fee now represents 2% of the client's AUM, which I think we can all agree is rather exorbitant, especially as it will continue at that level as long as it takes for the markets to build themselves back up (four years in the case of '08-'09). Clearly, this business model is better for the advisors who use it; but is it really better for their clients?

Flat fees enable advisors to work with clients who have small portfolios. This is a contention of flat fee advocates that both sounds good and probably makes a lot of sense. They point out that many younger professionals, executives and business owners have reached the point where they have relatively large incomes, but haven't yet accumulated substantial portfolios. Charging them a flat fee that is reasonable but lower than a firm's average AUM fee may make good business sense — chances are, with the help of an advisor at this point, they will become good clients in the future. Ignoring that this almost certainly would fall into the "unfair subsidizing" category under the third objection cited above, this situation doesn't conflict at all with AUM fees, but rather, works in tandem with asset management: creating a steady stream of future AUM clients.

To my mind, this "benefit" illustrates the flaw in much of the thinking about flat retainer fees: that they are incompatible with AUM fees. The reality is, as in the case of younger clients, flat fees not only make a great deal of business sense, they are a perfect complement to an AUM advisory business. Other examples of this kind of synergy between flat and AUM fees include college planning, health care advice and tax preparation.

Used in conjunction with AUM fees, flat fees have the potential to take advisory firms to the next level. However, as a replacement for AUM fees, flat fees seem to be two giant leaps backward.